Morningstar Magazine - October/November 2017 - 73

have proven able to find long-term opportunities
regardless of the market environment.
Adams, San Jose, and Taylor shared their
thoughts on July 31. The discussion has been
edited for length and clarity.
If a group of data scientists got together and tried
to duplicate your process and make a strategicbeta or smart-beta fund to compete with your process,
could they do it?

Andy Adams: I just got back from a conference
where a number of the presenters talked
about smart beta. I was pretty shocked by the
factors being used for the smart-beta models
at this point. A lot of the factors haven't changed
since I went to business school 20 years
ago; I have degrees in math and finance, and
worked on a quantitative factor model back then.

Where the rubber hits the road is how to weight
those factors and when to shift the weightings.
The jury is still out on whether smart-beta products
can move from factor to factor at the right time.

I'd love to be able to just run models and
spreadsheets but, especially in the small-cap
space, it's important to go out and visit
the companies and understand what's going
on behind the financial statements.
As a case in point, return on invested capital
is a great measure to look at. However,
without visiting a company to understand what
they're spending for maintenance versus
what they're spending for growth, it's difficult to
draw much of a conclusion from that number.
Don San Jose: There are going to be times when

things are changing in the real world that
models aren't capturing in real time. One of the
things that we look for is strong capital allocation.
The numbers may tell one story, but you need
to sit down with management and visit the plants
and see what they're investing in and try to
figure out whether it's organic growth or inorganic
growth or maintenance. While you may see
a certain quantitative factor come up in a model,
it may not be telling the true story. That is why
we make a point of visiting every company that we
invest in and a lot more that we end up not
investing in.
JB Taylor: I agree. I'd add that quant models

and smart beta are inherently a little shorter-term
in perspective. We can add the experience
of a long track record and a stable investment
team and also a very long-term perspective.
We can look for growth companies that may
not have a certain factor that is in vogue
in the market but have some sort of long-term
good competitive positioning that will allow them
to thrive.
We also spend a ton of time researching the
quality of a management team. There are aspects
that can't be quantified or measured. When
you find a phenomenal management team that
deploys capital in an efficient manner over
a long period of time with great success, that's
pretty special-and something that's very hard for
smart-beta models to capture.
JB Taylor, CEO and portfolio manager
at Wasatch Advisors.

San Jose: A lot of the quant models end up
getting out of a factor at exactly the wrong time.
Our longer-term perspective provides the

opportunity to zig when the market zags. With
these smaller-cap names, especially the lessliquid ones, if you have high conviction, that allows
you to build up positions when factor investing
may be going the other way.

Passive Competition
Have you seen distortions created by the flow
of money to passive strategies and strategic-beta
strategies in the small-cap area?

Taylor: It's not something that we spend a lot
of time discussing, because it's out of our
control. But there are moves in the market that
at times seem less rational, less based on
fundamentals, and you have to attribute some
of that to the massive inflows into passive
vehicles. In that period immediately after the
election, you had the Russell 2000 Value Index
jump 20% in something like 30 or 40 days.
The Russell 2000 Growth Index moved much less.
The components of the value index that
jumped the most were all these companies that
had been basically left for dead-companies
with inferior business models and lower returns
on capital in lower quality industries.
Adams: We noticed after the election a lot
of money moving into small caps. A correction
at some point will be a wakeup call for the
market, but it's just not a macro factor that we
focus on closely.
San Jose: Post-election is probably the most
recent time frame when we saw exaggerated
movement probably driven by flows to
passive. Prior to that was 2013, when biotech
was really ripping. That's not an area that
we commonly participate in, but I remember
thinking that this couldn't be all active generalists
pouring into one sector.
Taylor: Flows into passive strategies can create
headwinds or crosswinds in the short term. But
over the long term, flows into smart-beta strategies
and passive investment vehicles create opportunities for fundamentals-focused investors. When
those factors turn, when people start selling it
with the same momentum that they bought, then
good companies will be considerably cheaper.

global.morningstar.com/Morningstarmagazine

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